Can You 1031 into a REIT?

Written by Ricky Nave in Real Estate,Taxes

The IRS does not allow investors to directly 1031 exchange into a REIT, but you can indirectly 1031 into a REIT by first 1031 exchanging into a Delaware Statutory Trust (DST) which is already in the acquisition pipeline of a REIT and then later 721 exchanging your DST interest for ownership units in an UPREIT.

An UPREIT is an operating partnership owned by a REIT. That means technically, you still won’t own shares in a REIT. However, you get all of the same benefits because whenever you are ready to sell your REIT holdings, you can convert the UPREIT ownership units into REIT stock (usually 1-to-1) and then sell your new REIT shares in the liquid public markets.

In more detail, here’s how the process works, step by step:

Step 1: Do a 1031 exchange into a DST

Delaware Statutory Trusts (DSTs) are legally recognized trusts that typically manage the real estate of many investors, thereby allowing individuals to exchange their single property for an ownership interest in a much larger real estate portfolio without incurring any capital gains tax.

DSTs are like closed funds in that after they raise their initial capital, they do not raise any additional capital in the future. That means you’ll need to find a DST sponsor which is planning to create a DST but which hasn’t already collected a round of capital. There are sponsors who create a new DST every few months, so you shouldn’t have difficulty finding a DST that can accommodate you. The trick is to find one which offers a good deal after all the fees are accounted for.

Since your end goal is to hold a REIT investment, you’ll need to choose a DST which has a relationship with one or more REITs that could acquire it down the road.

After you find a DST that fits your needs, you can then do a 1031 exchange into the DST. DSTs do not file tax returns, and as such, you will report your share of the DST’s income on your personal tax return for as long as it takes the DST to be acquired by a REIT.

Step 2: The DST does a 721 exchange into an UPREIT

UPREIT stands for Umbrella Partnership Real Estate Investment Trust. An UPREIT is an operating partnership that owns and manages the real estate of a REIT and is itself owned by a REIT.

721 exchanges are the lesser known cousins of 1031 exchanges. In a 721 exchange, an investor contributes property to a partnership in exchange for an ownership stake in that partnership. Like a 1031 exchange, 721 exchanges are not taxable. However, to keep your tax deferral, you typically have to wait 2-3 years after 1031 exchanging into a DST before the DST will give you the option to convert your DST interest into ownership units in an UPREIT.

Step 3: When you want to exit, convert your UPREIT ownership units into REIT shares

REITs that operate through an UPREIT usually have identical investment returns whether you hold UPREIT ownership units or actual REIT stock. That means you can just hold the UPREIT units for as long as you want to invest in the REIT. If and when you eventually want to sell, you can easily convert your UPREIT units into REIT stock. If you chose a REIT which is publicly traded, you can then take advantage of the public market liquidity to sell your REIT shares.

It’s important to note that when you convert your UPREIT units to REIT shares, your deferred capital gains will be recognized, so it’s important to only do this once you are ready to sell.

The downside of 1031 exchanging into a REIT

The process outlined above can help you 1031 exchange into a REIT. This process can be very helpful if you need to sell (or have already sold) a property but can’t find a new property to 1031 exchange into. However, it also has downsides. After you convert your DST ownership interest into ownership units of an UPREIT, you can never go back. Your equity is now locked into the UPREIT, and the only way to get it out is to convert your UPREIT units into REIT shares which is a taxable event which you can’t 1031 your way out of since the IRS would deem the gain to be coming from the sale of a security interest in a partnership rather than from the sale of real property. It might still be worth it for you do a 1031 exchange into a REIT, but there are alternatives you should also consider before making a decision.

Alternative #1: Do a 1031 into a Delaware Statutory Trust

This was step 1 from above, and you can actually just stop here. Doing a 1031 into a DST helps you solve the problem of not being able to find a property to buy within the 1031 time window, while at the same time allowing you to do a future 1031 exchange on any gains (unlike a REIT or UPREIT).

DSTs have their own limitations, including:

  • DSTs are restricted from borrowing any new funds or renegotiating the terms of existing loans after they close, which can limit their ability to optimize their use of leverage, and
  • DSTs are not allowed to make capital calls or retain significant cash, which can put the real estate held by DSTs at risk in the event of financial crises or other serious market conditions.

Those limitations are manageable in some situations, but if you don’t like them, then there is another option.

Alternative #2: Invest into a Qualified Opportunity Fund (QOF)

Opportunity zones are specific census tracts that exist in every state. A qualified opportunity fund (QOF) is an LLC or other business entity which invests in real estate or businesses located in opportunity zones. If you invest capital gains into a QOF, then you can defer capital gains until 2027. That may sound much worse than a 1031 exchange (which allows you to defer capital gains indefinitely), but it’s actually better because of what comes next. You can hold an opportunity fund investment until 2046, and when you sell you don’t owe ANY capital gains tax. I’m not talking about a deferral of capital gains tax like a 1031. I’m talking about a permanent erasure of capital gains tax liability, as if Thanos snapped his fingers and made it disappear.

Opportunity zone funds are also very flexible. You can invest into an existing QOF or you can create your own QOF. If you create your own QOF, you can double the amount of time you have to acquire a property from the 6 months allowed by a 1031 up to 12 months or even more. For new construction projects, you can even qualify for 36+ months of total time to find and build your project!

And you aren’t even restricted to real estate with opportunity zones. You can actually invest in your own small business using a QOF. Most of the time, it’s even possible for you to invest in a QOF if you already have your funds locked up with a qualified 1031 custodian.

If you are trying to figure out how to avoid a big capital gains tax bill using a 1031 exchange, DST, or QOF, email me your questions through the form below. Unlike most forms on the internet, this one guarantees a response from an actual person with deep financial and tax knowledge.

Ricky Nave

In college, Ricky studied physics & math, won a prestigious research competition hosted by Oak Ridge National Laboratory, started several small businesses including an energy chewing gum business and a computer repair business, and graduated with a thesis in algebraic topology. After graduating, Ricky attended grad school at Duke University in the mathematics PhD program where he worked on quantum algorithms & non-Euclidean geometry models for flexible proteins. He also worked in cybersecurity at Los Alamos during this time before eventually dropping out of grad school to join a startup working on formal semantic modeling for legal documents. Finally, he left that startup to start his own in the finance & crypto space. Now, he helps entrepreneurs pay less capital gains tax.

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